2023-06-21 13:29:12 ET
Summary
- Fall in share price has created an opportunity.
- Headwinds facing beef, chicken and pork should abate.
- Valuation is attractive given long-term healthy outlook for protein.
Tyson
The recent fall in Tyson’s (TSN) share price created an opportunity for investors. Shares of Tyson are at their lowest level since the start of the pandemic. The company’s stock is currently trading at a market capitalization of $18 billion, down from a high of $36 billion, reached in February of 2022.
The company has suffered demand and supply disruptions across all divisions except for prepared foods. Beef has suffered from a lack of demand as consumers trade down to cheaper alternatives, whilst a drought in the West of the US has led to higher feed and cattle costs. Pork producers have too much capacity, whilst Chicken is suffering from declining prices and higher input costs. With the exception of the prepared foods, the current situation for all of the product lines can only be described as terrible.
However, when the outlook is worst, it is often the best time to invest in cyclical names like Tyson. Lower beef margins should mean less new added industry capacity, whilst cattle prices might have peaked. The pork market should rationalize with time, whilst the company continues to improve capacity utilization.
In the long-term, the outlook for protein is decent. Chicken is the company’s fastest growing-end market and accounts for $17 billion out of the $53 billion of total company sales or 32%. The company is undergoing a $1 billion cost-cutting initiative that should help margins. Tyson’s prepared food continues to earn good margins and the company plans to grow this business. Finally, international markets are expected to be the biggest growth area going forward and Tyson is in a good place to capitalize on it.
The company recorded a loss in the most recent quarter; however, I expect net income margins to improve and return to a long-term average of 3.5%. As margins improve, the company’s stock price should too. Investors brave enough to ride out this cycle, could be well rewarded.
Overview
Tyson produces about one out of every 5 pounds of chicken, beef and pork sold in the U.S. and is the largest U.S. meat supplier. Sales to Walmart account for 18% of sales. Tyson and other meatpackers posted record profit margins during the pandemic as labor shortages in plants constrained supply and pushed prices higher.
However, the company’s net income of $3.2 billion in 2022 and $3.0 billion 2021, swung to a loss in its latest quarter as the meat packing industry is struggling from changing consumer taste, excess capacity and higher input costs.
Beef Boom to Bust
The primary reason for Tyson’s drastic change in economics is due to the beef segment. Beef is the largest of the company's segments and accounted for $22 billion of the company’s $52 billion of revenue in 2022. The segment made an operating profit of $2.5 billion, out of a total of $4 billion, for the company as a whole in 2022, and the segment's fortunes have an outsized impact on the company.
Since the pandemic, the beef segment's operating margins have averaged 14%. This was up from an average of 4% over the period from 2014 to 2019. This period of high margins is now coming to a crashing halt.
Beef Segment Financials (Company Financials )
Consumers are choosing to buy chicken and cheaper cuts of beef as shoppers become more cost-conscious . In addition, the cost of cattle have also increased as ranchers have shrunk the size of their herds after years of drought. Parched grazing pastures have required cattlemen to spend more on supplemental feed. The lower demand and higher costs have squeezed producers such as Tyson. The beef segment is expected to barely make any operating profit in 2023 and the segment's operating income fell to $8 million in Q2, down from $638 million in Q2 last year.
Beef Green Shoots
The last time beef prices increased dramatically was in 2015. Back then you saw a similar income decline from the beef segment. However, as cattle prices declined post 2015, the beef segment's margins recovered. I would expect the beef segment to recover in a similar way as we moved past the current inflationary environment.
Cattle Prices (FRED)
Tyson's has said there are signs that we are near the bottom of the beef cycle. Fewer cows are being harvested and there is some heifer retention. This should increase the cattle supply and lower the price of cattle, ultimately helping margins.
Also, expansion plans that beef producers such as JBS, Cargill and National Beef Packing had planned in the wake of the high margins over the last years appear to be put on hold. In line with what we might expect from other producers, Tyson’s capex is also expected to peak this year, spending $2.3 billion, which is expected to go down to $1.5 billion in 2024. Over time less added capacity will help earnings recover.
Chicken Headwinds
The second largest of the company's segments is the Chicken segment, which consists of 186 chicken facilities and handles 47 million heads per week. Unlike beef and pork, the company breeds the chickens that are produced.
The company’s chicken business has had operational struggles in the past and had an operating loss in 2021. This loss was as a result of legal fees relating to price fixing accusations. In addition, a new male breeder was rolled out in 2020 to produce more efficient chickens. This backfired and resulted in unexpectedly large numbers of unhatched eggs.
Chicken Segment Financials (Company Financials )
More recently, the supply of chicken rose due to processors ramping up production across the industry and company profits have been hurt as chicken prices fell sharply at the end of 2022. At the same time, higher chicken feed ingredient (corn and soybean meal) costs are hurting at processors such as Tyson and rivals Pilgrims and Sanderson farms.
Chicken Potential Recovery
Similar to beef, the last time that chicken and feed prices spiked was also 2015. However, over that period the Chicken segment was able to remain profitable as Tyson was able to pass the costs onto consumers. At the moment there is a lagged effect hurting margins, but over time I believe the segment will do better, as was the case in 2015.
The company was able to increase internal production by 6.4%, in the latest quarter. At the same time feed input prices are starting to decline. Finally, the price-fixing allegations seem to be behind the industry. The government’s high-profile case against several poultry executives ended in a second mistrial in March. The government has said that they might try the case again, it does however appear that much of the risks related to the acquisitions have been removed.
Chicken Prices (FRED) Price of Corn (FRED) Price of Soybean Meal (FRED)
Pork Excess Capacity
Pork accounted for $6 billion or 13% of sales in 2022. The company acquires live hogs from independent producers and with seven facilities that handle 469,000 heads per week. Pork producers are currently struggling with too much capacity in the system. The segment recorded an operating loss of $31 million in Q2, a substantial change from the operating profit of $59 million in Q2 last year. It is hard to say when the market will correct itself, but over time margin producers should reduce capacity and profits improve. If we look back, the price of swine also increased in 2014, and subsequently earnings also took a hit. In the end, margins recovered following previous down cycles, I expect the same to happen this time around.
Company Financials Price of Swine (FRED)
Prepared Foods Continues Doing Well
Prepared foods represented 19% of the company's sales in the first half of the year, but almost all of the company’s operating profit. Over the last 20 years the prepared food business has grown faster than other segments. This was in part due to the acquisition of Hillshire Brands for $8.6 billion in 2014. This segment is the best Tyson business, and the area the company wants to grow. At the last investor day the company said it believes the long-term average prepared foods operating margins should be 10%-12%, compared to pork 5-7% and chicken 7-9%.
Chicken Segment Financials (Company Financials )
International Turnaround and Growth Opportunity
The international segment is the smallest of all the segments. It has never made any real profit, however, management is optimistic that it will finally show decent operating income in 2023. The company has branded portfolios across Thailand, Malaysia and China. However, a large part of the business is low margin as it supplies food service companies such as McDonald's.
Segment Financials (Company Financials )
At the investor day in 2021, the company said they expect the international segment to grow between 18-20% over the next 3 years. The biggest driver of global protein consumption over the next decade is expected to be Asia and Tyson is expected to benefit from this growth.
Risks
Leadership Uncertainty
Tyson was started in 1931 by John W. Tyson and the company is still controlled by the Tyson family. The company has two classes of stock, A shares are entitled to one vote per share, whilst B shares get 10 votes. It is through B shares ownership that the Tyson family has nearly 71% of the total voting rights.
The head of the clan, John H. Tyson, has been chairman of the board since 1998 and is the grandson of the founder. The lack of change at the chairman level is in contrast to the CEO position which has seen many individuals try and run the company. Since 2016, Donnie Smith (2009- 2016), Tom Hayes (2016- 2018), Noel White (2018- 2020), Dean Banks (2020 - 2021) and Donnie King (2021 - Current), have all led the company.
The CFO role has also not gone without some controversy. The Chairman’s son, John Randall, was appointed to CFO role at the age of 32, making him the youngest CFO in the S&P 500.
Debt Not Inconsequential
Tyson had net debt of $7.3 billion at the end of the latest quarter, and an investment grade (BBB+) credit rating from S&P. The company’s credit agreement contains a covenant that is triggered if EBITDA / Interest exceeds 3.5x. The company has said that interest for 2023 is expected to be $340 million. At that level of interest expense, the covenant would be breached if EBITDA fell below $1.2 billion.
S&P Ratings expects the company’s EBITDA margin to fall below 5% for fiscal year 2023 and then increase to 7% in 2024. This would result in EBITDA falling to $2.7 billion and then increasing to $3.7 billion by my calculations. Similarly, the company has said that it expects the second half of 2023 to look like the first half, implying full-year EBITDA of $2.4 billion. These estimates appear to show that the covenant is unlikely to be breached at this point.
Valuation
Over the last 15 years, the company has had an average net income margin of 3.5%. If the company returns to its long-term average net income margin, it should earn net income of $1.9 billion in a ‘normal’ year, resulting in a PE of 10x at the current market capitalization.
In the past, the company has said that it expects sales to grow by 3% per year. If we assume net income is equivalent to free cash flow to equity in the long run, a long-term growth rate of 3% and a cost of equity of 10%, I get a valuation of $27 billion, about 50% above the current equity value.
Another way to look at this business is to do a sum of the parts. The Prepared Foods segment’s peer Hormel trades at an enterprise to sales ratios of 2x. This would imply a generous $19 billion valuation for the segment, leaving a $6 billion valuation for beef, chicken, pork and international. Not bad when considering these other businesses had combined operating income of $2 billion in 2019.
There are many ways to value the company. The impact of COVID on the industry is hard to determine and no one knows for sure how the next few years are going to play out. However ultimately the stock’s performance will follow earnings, and when it comes to the question of earning recovery, that is certainly a question of when, not if.
For further details see:
Tyson: Recent Fall In Share Price Creates An Opportunity